Banks' capital adequacy

The good tailors of Basel

Regulators are still struggling with their monster regime for banks

THE Basel committee of rich-country bank supervisors has learned not to make rash promises about its timetable for setting a new capital regime for banks. Originally planned for 2004, the regime, called Basel 2, was knocked back a year last June and has now slipped even further. Without an official announcement, members of the committee talk about a starting date of 2006.

Basel 2 will revolutionise the supervision of leading banks, adjusting the capital required by the regulators to the banks' own measures of the risks they run. It is intended to replace the crude workings of Basel 1, in force since 1988, with greater detail—far too much, indeed. At the same time, the capital rules are also being designed to suit all the other banks in industrialised countries, and eventually worldwide. A version must be applied at the same time to all banks and investment firms in the European Union, under an EU directive yet to be written.

The exercise was never expected to be easy. Critics, including The Economist, suggested that it could be done more simply by starting with a small group of the world's biggest banks. Now it seems that the Basel rule makers are beyond the point of no return: they are determined to have a workable version of Basel 2 agreed by the end of the year. Before then they will ask banks to road-test a newly calibrated set of rules, probably in June, so that they can produce a final consultation paper in the last quarter of the year. This is the third test, or quantitative impact study, designed to ensure that the rules will not reduce overall capital in the banking system, or distort financial markets.

The biggest challenge is to persuade banks to progress towards a more advanced measurement of risk, using their own credit ratings rather than those of external agencies such as Moody's and Standard & Poor's. They need to be encouraged by a potential capital saving, but not one that gives them too great a competitive advantage over less sophisticated banks. Previous calibrations have failed to get this right. The first proposals gave little advantage to banks using advanced methods of measuring; later drafts gave too much.

A handful of other knotty issues need to be unravelled before June, mostly in the quantitative part of the regime, known as “pillar one”. There, the treatment of loans to small and medium-sized companies raises concern, especially in Germany; too heavy a charge might starve these companies of credit. The Basel experts think that they have fixed this issue by acknowledging a diversification effect in lending to smaller firms: for banks that spread their lending among small businesses, risk charges can be lowered.

A related task is to modify—even reverse—the incentive given to short-term rather than long-term lending. The Germans, again, worry that Basel 2 will erode the kind of long-term bank lending that is the backbone of corporate Germany. It could also reduce developing countries' access to long-term capital, making them more crisis-prone.

The Basel experts fear that banks will be tempted to arbitrage the difference between the risk-weighting demanded by regulators for a portfolio of loans sold as securities and the risk suggested by their own credit-risk models. Regulators have made such models taboo since they examined them in 1998 and found them wanting—they need huge amounts of data which have not yet been collected. Banks' own models have not been considered for Basel 2, but a regulator says they may be discussed in four or five years' time.

Finally, there is the issue of procyclicality, a concern that a risk-sensitive regime will require banks to raise more capital, and cut back lending, at the toughest part of an economic cycle, so needlessly exacerbating a downturn. Basel experts think this danger can be overcome by asking banks to stress-test their portfolios during good times, for worst-case outcomes, and then build up capital accordingly. Surely a simpler answer is to require an extra buffer of capital—which most well-managed banks have anyway. Yet that would hardly be in the spirit of a risk-based regime.

There is no doubt that the Basel 2 exercise has heightened awareness of risk among banks. It has prompted them to overhaul their credit-scoring methods and to tighten up their operations. It has also forced them to get to grips with a hitherto unregulated area of risk: Basel 2 requires capital as a buffer for operational risk—losses from events such as business interruptions, bomb attacks and rogue trading. The argument continues, though, over whether this risk is measurable and can be solved by carrying more capital. Is capital a better buffer against a rogue trader than the assurance of better controls?

Supervisors are encouraging a shift from capital charges based on hard ratios to charges that reward good risk management. A second part of the Basel 2 regime, called “pillar two”, relies on continuous review by supervisors of a bank's risk management, and of its handling of exposures that cannot be assessed in merely quantitative terms. The last part, “pillar three”, encourages more public disclosure by banks of their structure, performance and risk positions.

The endeavour to build a comprehensive regime, however, threatens daily to add complexity rather than to shed it. The Basel committee touchingly notes that it will seek to balance the need for sensitivity towards risk with the need to be “sufficiently clear and flexible”. One committee member confesses that the opposite tends to be true. “As soon as you develop an approach, it's not too long before you hear from the banks complaining about something. So you adjust—at the cost of a more complex calculation for everybody.” Another committee member refers to the “great monster” of Basel 2 .

A man went to his tailor for the final fitting of a suit and found one sleeve and one leg too short. “Hunch yourself like this, and bend your leg like that,” said the tailor, “and you'll find it fits.” And so it did. The man paid his tailor and hobbled into the street. “Look at that poor fellow, all doubled up,” said a passer-by. “Well,” said his companion, “at least he has a good tailor.” The tailors of Basel 2 may yet produce a similar suit.